ITIC regularly monitors the G-20 Meeting of Finance Ministers and Central Bank Governors. The group met on 22-23 July 2016 in Chengdu, China. Please see the link to Bloomberg News for the full text of the communique that was issued on 24 July. A number of key fiscal issues that are of interest to ITIC’s sponsors – and relevant to our programs, working groups, and regional tax forums – were discussed.
In particular:

Point 3, which emphasizes the need to “foster confidence and support growth.” The ministers also discussed “making tax policy and public expenditure more growth-friendly.”

Point 6, which discusses the 2030 agenda for sustainable development, including the importance of the multi-lateral development bank’s investment priorities to “catalyze private investment.” You might recall that “increasing private sector investment by MNCs” is one of the sustainable development goals.

Point 10, which addresses the G-20/OECD inclusive framework on BEPS. In particular, it points out the “timely, consistent, and widespread implementation of the G-20/OECD BEPS package and … specific challenges faced by developing countries.” This is among the reasons why ITIC includes sessions on BEPS at each of our regional tax forums. We believe it’s important to discuss BEPS in the context of each country’s investment climate as well as their domestic revenue mobilization objectives.

The G-20 acknowledged “the establishment of the new Platform for Collaboration on Taxation by the IMF, OECD, and UN, and their recommendations on mechanisms for effective technical assistance in support of tax reforms.” ITIC will continue to work with each of these institutions as we have in the past. This includes participation by a combination of these organizations at our regional tax forums.

Point 11, which recognizes the importance of the “role of tax policies in our broader agenda on strong, sustainable, and balanced growth…” We are pleased to see they concluded this point by asking “the OECD and IMF to continue working on the issue of pro-growth tax policies and tax certainty.”

Point 13, which reinforces ITIC’s work on combating the illicit trade of excisable goods as well as our cooperation with the OECD Taskforce on Combatting Illicit Trade by recognizing FATF’s progress in its new “Consolidated Strategy on Combating Terrorist Financing.”

While taxes continue to play a significant part of the G-20 Finance Ministers and Central Bank Governors agenda, we are pleased to see the repeated references for more growth friendly policies and tax certainty. We are hopeful that the actions identified by the G-20 will succeed in their quest to “foster confidence and support growth.”

The IMF’s Fiscal Monitor April 2016 (“Acting Now, Acting Together”) looks at fiscal policies for innovation and growth. Fiscal policy can promote growth in productivity by encouraging innovation.
The global recovery is slowing and fiscal risks are rising. Public debt ratios are being revised upward and the largest revisions are in emerging market and middle income economies. Commodity exporters, including the oil exporters of the Middle East and North Africa, have been hit hard, and advanced economies have high levels of public debt, low inflation and sluggish growth.

In advanced economies, the focus should be on fiscal measures that boost both short- and medium-term growth (such as infrastructure investment) and policy actions that support the implementation of structural reforms. The IMF suggests that states in the euro zone should make full use of the existing room within the Stability and Growth Pact to increase public investment. In Japan and the US, policy space can be created by commitment to credible medium-term consolidation plans.

A sustained increase in economic growth of 1 percentage point could reduce debt ratios in advanced economies to their pre-crisis levels within a decade. These economies must accelerate structural reforms, including tax and expenditure policies that reinforce incentives to work and invest, and boost productivity growth.

In commodity-exporting countries, public spending has to be brought in line with reduced resources. The fiscal adjustment could be helped by further revenue diversification. In other emerging market and developing economies, an important challenge is to create budgetary room for necessary expenditure on public services, health, education, and infrastructure. This could be done by implementing pro-growth structural reforms, better mobilizing revenue and improving expenditure efficiency. Capacity building in the field of revenue mobilization is required to achieve the Sustainable Development Goals.

Comprehensive, reliable, and timely public reporting on public finances can also reduce vulnerabilities by fostering more informed and accountable fiscal policy. Developing economies should closely monitor the rapid increase in corporate debt. Tax policy can be combined with macroprudential measures to limit excessive leverage.

Fiscal Policies for Innovation and Growth

Improvements in productivity are at the top of the global policy agenda. The decline in total factor productivity (TFP) explains a significant part of the overall decline in growth potential in advanced economies since the early 2000s, and more recently in emerging market economies. This can be improved by structural reform of labor and product markets, but fiscal policy is another important way to improve TFP.

Fiscal policy is a potent instrument for productivity growth through innovation. Innovation can be built on a base of strong human capital and a business environment that provides adequate incentives. Macroeconomic policies that provide higher growth are important because growth permits firms to more quickly recover their sunk costs, and it therefore encourages R&D investment.

The IMF focuses on three channels of innovation that could be improved: research and development (R&D), technology transfer, and the promotion of entrepreneurship. These three pillars of innovation affect different countries to varying degrees -- for example, R&D policies are more important for advanced economies that are closer to the global technology frontier. Policies that encourage technology transfer and entrepreneurship are also important to emerging market and developing economies.

R&D Incentives

Private R&D undertaken by one firm may increase productivity in other firms through knowledge spillovers. These positive externalities imply that market forces will lead to an underinvestment in R&D compared with the level that is socially efficient. This can be addressed by fiscal instruments to promote private R&D. Fiscal policy can promote R&D in the private sector by providing incentives in the form of subsidies and tax relief. The effectiveness of these policies depends on how they are designed and implemented.

Tax incentives could be in the form of tax credits, enhanced allowances, accelerated depreciation, or special deductions for labor taxes or social security contributions. The tax incentives are usually available to all firms that invest in R&D, although they can also be targeted to particular groups of firms. They generally provide a level playing field, but private-sector R&D decisions may not adequately address the complex knowledge spillovers associated with R&D.

Subsidies for R&D are often specifically targeted at particular projects. If targeted well and based on accurate information, subsidies can be more effective than tax incentives. Subsidies can also bring about non-market benefits (such as a cleaner environment).

Best practices in provision of R&D incentives include the provision of payroll tax relief for researchers and refundable R&D tax credits for small enterprises. New enterprises often face loss-making situations in their opening years, and a refunded credit in the case of a negative tax liability is more useful to them. R&D incentives can also be cheaper if they target incremental R&D above a certain baseline.

Encouraging Technology Transfer

Most technology creation occurs in a small number of advanced economies, such as the G7 countries. The technologies are disseminated to the rest of the world through imitation and absorption. Technology transfer is important for productivity growth.

Technology transfers take place mainly through international trade and foreign direct investment. Firms import intermediate goods and capital equipment that include foreign technology. Multinationals transfer technology to their affiliates throughout the world by foreign direct investment. Inbound FDI may produce positive productivity spillovers through interactions between the multinational affiliate and local firms, worker turnover or improved management practices.

Emerging markets and developing countries often implement tax holidays or tax exemptions in special economic zones to attract FDI. These incentives erode the tax base. Also, it appears that tax incentives often have no effect on the investment decisions of multinationals. Instead, institutional quality in a target country is more important for multinational investment.

Governments of developing economies should invest in education, infrastructure and institutions to facilitate the absorption of technologies from advanced economies. The provision of tax incentives to attract foreign investment is generally ineffective and depletes the tax base.

Promoting Entrepreneurship

Productivity gains and innovation also result from new firms engaging in experimentation and risk-taking. New firms expand the technology frontier by engaging in more radical innovations, while established firms are more likely to concentrate on incremental innovation to improve their existing products and processes. Competition from new entrants also spurs innovation by incumbent firms, especially in the technology sector.

Although business entry rates are typically higher in emerging economies, many of these new entrants are “necessity driven,” from economic need when alternative work opportunities are absent, rather than “opportunity driven” entrepreneurship, which is more closely related to innovation. An important development goal in many emerging markets and developing economies is therefore to increase the share of entrepreneurship that is driven by opportunity.

Tax incentives aimed at all small enterprises may merely serve as a disincentive for these enterprises to grow, as tax rates may increase sharply after the firms reach a certain size and lose the tax incentives. Innovative entrepreneurship can, however, be encouraged by fiscal policies that are targeted toward new enterprises rather than just toward all small enterprises. The entry of new firms can also be facilitated by tax simplification.

Conclusions

The IMF study concludes that good fiscal stabilization policies promote R&D and can help firms maintain spending on R&D during recessions. Governments should do more to promote R&D, and private investment in R&D in advanced economies should be increased by 40% (on average) to achieve efficient levels. This could increase GDP by 5% in the long term in those economies.

Governments can invest more in public R&D that could also advance the research activities of private firms. Research subsidies and tax incentives for private R&D can improve productivity growth. Some existing policies are not efficient -- for example, patent boxes may not stimulate R&D efficiently and may become part of aggressive tax avoidance strategies.

Technology transfer in developing economies requires better institutions, education and infrastructure. Tax incentives commonly used to attract FDI are largely ineffective. These economies should strengthen their capacity to absorb foreign technology by improving the human capital base and infrastructure.

Income taxes have only modest effects on business entry rates. Preferential tax treatment of small firms should be avoided as it may create a barrier to further growth of those firms. Tax relief targeted to new firms can, however, promote entrepreneurship and innovation.

Tax issues formed part of the discussion at the G20 Finance Ministers meeting in Shanghai on 26-27 February. As indicated in the final Communique, Paragraph 7 makes several points in support of broad, consistent and effective implementation of the BEPS project, including:

Commitment to a consistent global approach, and encouragement to non-G20 countries, especially developing countries, to join in the OECD designed framework (see below).

Awareness of the specific challenges faced by developing countries in BEPS implementation and support for building capacity for such countries.

The anti-MNC context for these G20 discussions is rooted in OECD estimates of of $100-240 billion in BEPS-related revenue losses. And the 2015 Addis meeting on financing for development has not resulted in material steps to help developing countries improve their capacity, thus raising a concern is that BEPS rules will be misused and/or selectively applied to MNCs.

Other tax-related items in the Communique include:

Commitment to the standards for information exchange on request, and Automatic Exchange of Information (AEOI), with a request for all financial centers and jurisdictions to do so by 2018 at the latest;

A request for all countries to join the Multilateral Convention on Mutual Administrative Assistance in Tax Matters;

Endorsement of the proposal to develop a tax platform jointly by the IMF, OECD, UN, and World Bank Group, with a request for recommendations on how countries can contribute funding for tax projects and direct technical assistance by July 2016;

Recognition of the role of tax policy in achieving sustainable economic growth.

While much of the above is not new, sponsors should note the increased interest in bringing in non-G20 countries into the process, and a willingness to look at new ways to support capacity building in developing countries. ITIC will monitor the proposed “tax platform,” and inputs from sponsors are of course welcome at any time.

The only specific commitment in Paragraph 7 relates to China’s pledge to establish an international tax policy research center, which would also provide technical assistance to developing economies. By way of background, the new OECD framework allows all interested countries and jurisdictions to join in efforts to update international tax rules, participating as BEPS Associates in an extension of the OECD’s CFA.